Price Inflation Could Imperil the Economic Recovery

Dean Foreman
Posted September 1, 2021

One of the great stories of the U.S. energy revolution is that, as it broke productivity records, it ultimately imposed downward pressure on the prices for energy and other goods and services, benefiting U.S. household budgets.

Yet, so far in 2021, prices have risen for energy and most other goods – and could bring unfavorable surprises for macroeconomic policies and households alike.

Consumer price inflation has emerged as a key uncertainty for economic and energy policy, rising in July 2021 to 6.4% above July 2019 levels. This was its highest reading since the Great Financial Crisis in 2008 and may understate what consumers have actually paid, due to delays in seeing the impact of higher rent/real estate prices as well as technicalities in reflecting the basket of goods that consumers purchased.            

From an industry standpoint, readings on producer price inflation (PPI) have skyrocketed with changes this year versus 2019 ranging between 12% and 84% for some business segments. Since PPI gauges changes in the cost of inputs, the higher costs for commodities being processed, steel, labor and service costs have undoubtedly contributed toward broader price inflation. Consumers are now paying more for goods and services, often without corresponding increases in their paychecks.

A pivotal question is whether this price inflation is temporary or likely to endure. The answer matters to macro policy on interest rates and, consequently, financial asset and retirement account values.  Additionally, it also could influence employers’ decisions about when and whether to hire, invest and grow. 

Although there are many examples where it appears price inflation could moderate as the economy normalizes in the wake of the 2020 COVID-19 recession, the concern here is that the damage has already been done to investments that generally take years to develop.  This is particularly true of the natural gas and oil industry.

Consequently, if economic growth – and energy demand in tandem with it – continues to remain on track, the recent weakness in oil and gas-related capital investments could translate into further upward pressure on prices.

In economics, we often say that the long run is made up of many short runs. As policymakers look toward the energy transition, they also must realize that shocks can have unintended consequences, effectively freezing decision making until the path forward is clearer.

Let’s unpack some details on these issues, beginning with the global economy and price inflation.

The left panel shows global annual real GDP growth consensus estimates through 2023, with growth of 5.0% year on year (y/y) in 2021. Three things of note: 1) these estimates have risen over the course of this year despite ongoing concerns about the pandemic and price inflation; 2) the projections are lower in 2022 and 2023 but remain well above the long-run historical average growth rate of 2.5% per year; and 3) a 5.0% y/y rate this year is a scorching pace for global growth – the second highest in nearly 50 years, fueled by government and central bank efforts to propel the economy past the 2020 COVID-19 recession. 

In a healthy economy, one should expect an inflationary response to accompany strong and sudden growth. The middle panel highlights International Monetary Fund (IMF) estimates of price inflation for the world and by region for advanced and emerging economies.  IMF reports relatively modest current and prospective price inflation across the board – surprisingly ordinary. 

By contrast, since 2020 was anomalous, the right panel charts two-year changes in U.S. producer price indexes by industry segment between July 2021 compared with July 2019.  These changes ranged between 11.8% and 83.5% – multiples greater than measures of broad consumer price inflation. 

Industry-specific producer price indexes, particularly among commodity-related sectors, can be cyclical and volatile, but the recent increases generally stand among the top 10% of two-year changes in the respective index categories and thus are high by any benchmark. Commodity/bulk material input costs are up so far in 2021, along with those for labor, steel, and engineering / project management services. 

In general, increased and uncertain cost escalation could deter investments and compound the existing litany of concerns following the 2020 COVID-19 recession. 

So, which measure is likely to be indicative of the near-term energy future? Next, let’s look at industry capital investment trends.

The left panel charts the flow of capital investments by about 200 energy industry companies across the value chain, which fell to $37.4 billion in the second quarter of 2021, its lowest point on record since 2008. Historically, the majority of capital investment stems from upstream resource development and global integrated companies with large upstream operations. These segments have remained under pressure despite recent improvements in the price environment, as additionally evidenced by the fact that global drilling activity in July 2021 remained 41.7% below that of July 2019 per Baker Hughes.     

Meanwhile, the right panel shows API’s monitoring of $178 billion in large capital projects spanning oil and natural gas pipelines, processing, storage, refinery and petrochemical expansions and liquefied natural gas export terminals under construction. Although $178 billion is a sizeable amount, it fell by $110 billion or 38.2% from the same quarter last year. 

Consequently, we see a potential collision course between competing trends of 1) apparently buoyant economic and energy demand growth, coupled with modest price inflation, versus 2) potentially acute escalation in industry costs despite a relative dearth of energy industry capital investments into longer-term projects.

In our next segment, we’ll relate these investment trends to the production outlook for oil and natural gas. Suffice to say it’s a critical time in the economic recovery, and higher energy prices – higher than those that likely went into GDP growth projections – could be a body blow to both macro policies and consumers.